The Business Divorce Law Report
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An equitable accounting is a cause of action that requires those in control of the finances of a closely held business to account for their use of the money.
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An accounting a two-stage process. First the controlling party must render an account of how it used the assets of the business. Then there is a proceeding for the minority to object to the accounting.
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When a court finds that the party in control has misappropriate or misued the assets of the company, it can order repayment.
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A minority member should demand an accounting before seeking the accounting in court and be prepared to support the request with plausible claims of misconduct.
For many minority owners of closely held businesses, the finances are sometimes a black box. There is a result, but where that result came from is unknown. The cause of action for an equitable accounting is a tool that gives the owners who don’t have day-to-day management roles a look inside the black box of the closely held company’s finances.
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The term black box comes from engineering and describes devices or systems that give a result from a set of inputs, but the process inside is a mystery. This lack of transparency makes it challenging to troubleshoot issues or make modifications to the black box without specialized knowledge or access to its internal components.
The same may be true of the finances of the closely held corporation, limited liability company, or partnership, particularly when there are questions about the majority’s behavior. Where, for example, there is a question about the misuse of an LLC’s assets, the minority may be able to sue and hire its own forensic accountants to reconstruct the workings of the black box. But if they can prevail in a cause of action for an equitable accounting, they shift the responsibility for the process to those in charge of the books.
There is a significant difference between putting the responsibility to explain the use of the assets of the LLC and pay back what was improperly taken and simply getting access to records. That has been the central point of a number of cases involving claims for equitable accounting. We examine some of those cases here under New York and New Jersey law, including a very recent decision from a federal court in the Southern District of New York applying state law.
There are some conclusions to be drawn from the caselaw discussed here. In order to protect the right to seek an acocunting, the prospective plaintiff should consider these steps before filing suit:
- Make a clear demand for the accounting and explain why it is being requested.
- Be prepared to articulate a factual basis for a breach of duty, for example, misappropriated assets or unexplained expenses.
- As part of the request, demand to review “primary” documents such as receipts, invoices and bank statements.
- Give the party with control of the property an opportunity to respond and if there is no response, document that failure.
Accounting, or rendering an account, is a term of art in the law of fiduciaries. It refers to a process in which the party with control of assets belonging to a third party must identify the assets that came into his or her possession and explain how the assets were used or spent. The owners of the assets have a right to object to the uses,typically expenses of some type, and if a court finds that the expense was improper, the accounting party will be held liable for that amount.
The process is common in estate and trust administration, in the appointment of guardians, conservators and in powers of attorney. There are cases that apply the same process to other types of fiduciary relationships, from cemetery maintenance funds to business partners. The duty to account is frequently contained in a statute, but it is also enforced through the common law.
This remedy is often sought in cases where there has been a breach of fiduciary duty by one or more of the owners of the business. For example, if one of the owners has misappropriated assets from the business or has otherwise acted in a way that has harmed the interests of the other owners, an equitable accounting may be ordered.
In some states, such as California and New York, equitable accounting is specifically mentioned in the state’s business laws. In other states, the remedy is implied by the common law. I
In order to obtain equitable accounting, the plaintiff must typically prove, first, that the parties have a fiduciary relationship and that one of the parties has been entrusted with the property of the other — for example, the assets of a closely held business. Second, the party seeking the accounting must show that it has no adequate remedy at law for money damages.
In some states, including New York, the party seeking an accounting must establish that it first requested an accounting from the business and was refused. In New Jersey, the party seeking the accounting also has to show that the factual circumstances are sufficiently complicated to justify the process.
The common defense and one that some courts will find to have some merit is that the process of collecing and reviewing financial records is a substitute for a court-ordered accounting. A recent decision from the Sourthern District of New York, Siglit v. Kahlon provides a good overview of the elements of an equitable accounting and the viability of the cause of action.
The case revolves around the defendant Jossef Kahlon and TJM, a private equity firm that purchased and resold penny stocks and passed along profits to a third party. In 2012, the SEC sued Kahlon and TJM and they settledwith the SEC for $2.2 million.
After the judgment the plaintiff Yehuda Siglit claimed that Kahlon continues to own property of TJM that he claims to have sold to a third party for $10 million. He commenced an action, seeking an equitable accounting against Kahlon.
Kahlon sought summary judgment arguing that plaintiff had failed to establish a right to an equitable accounting. He contended that that there was no showing of irreparable harm and that Sigalit had not sought to exercise her rights to gain access to documents. The court denied the motion.
Equitable accounting, the court held, is a legal process that requires a fiduciary to show what they did with the principal’s property. It occurs in two steps. First, an interlocutory decree is issued requiring the fiduciary to make an accounting, and a hearing is held to establish the final amounts owed to the principal.
The elements of an equitable accounting under New York law are straightforward: (1) a fiduciary relationship; (2) entrustment of money or property; (3) no other remedy; and (4) a demand and refusal of an accounting. and the court rejects Kahlon’s statute of limitations argument because Sigalit does not need to allege a breach of fiduciary duty to sustain an equitable accounting claim.
The trial judge noted that the right to an equitable accounting is separate and distrinct from the right to inspect the books and records of a business, and that it is not mooted by the production of documents.
the right to inspect company books and records is separate and independent from the right to an equitable accounting, which ‘require[s] a person in possession of financial records to produce them, demonstrate how money was expended[,] and return pilfered funds in his or her possession.
The court also noted that it was not necessary to allege a breach of fiduciary duty to secure an accounting under New York law. That holding, however, does not represent a principle that has been uniformly accepted in in the state courts. In a number of decisions, the courts have held that there must be some plausible claim of wrongdoing and that an ordinary claim for breach of contract would not satisfy the complaining party.
In these cases, the courts have required a showing of some form of misconduct or breach of duty in order to grant an accounting. Therefore, while the court’s ruling in this particular case may provide a helpful precedent, it is important to consider the varying interpretations of the law across different jurisdictions within New York state.
In New Jersey, the elements of an equitable accounting also require the existence of a fiduciary relationship. But New Jersey courts invoke the remedy far less frequently and impose the requirements the nature of the account is complicated and that there is a need for discovery. One of the more frequently cited cases, Borough of Kenilworth v . Graceland Memorial Park, articulates the elements as:
An accounting in equity cannot be demanded as a matter of right or of course. The exercise of the equitable jurisdiction to compel an account rests upon three grounds,—first, the existence of a fiduciary of trust relation; second, the complicated nature of character of the account; and third, the need of discovery
Minority members of closely held businesses often charge into litigation without laying the groundwork for a viable accounting claim. But taking care to document the need for the equitable accounting can improve the probability that it will be accepted by a court and shift the responsibility for opening the black box to the defendant.
The potential financial losses and risks faced by minority owners of closely held businesses who fail to act can be significant. Equitable accounting is a remedy that can mitigate these risks and protect the minority’s financial interests.